Can Bad Credit Business Borrowers Be a Good Investment?

When you apply for a loan, that all-important three digit number--your credit score--determines your fate. Small businesses are no exception. Most small business lender looks at a small business owner’s credit score in determining whether to approve him or her for a loan. Banks in particular rely heavily on personal credit score and are unlikely to give a loan to a business owner with a credit score under 650. Should lenders and investors write off such borrowers?

Disclosure: I am the co-founder of FitBiz Loans and Fit Small Business which has financial relationships with many of the companies mentioned in this article.

Credit Score is Still a Priority for Banks

If you talk to any big bank’s business lending division, they will do almost anything to avoid giving specifics on credit score. Most will admit that credit score factors into their underwriting process, but they won’t tell you what an important factor it really is or give you a specific credit score cutoff below which they will not consider an applicant for a loan.

Credit score is probably the single most important criterion in getting a bank loan, especially in today’s post-recession climate. Based on my experience working with small businesses in need of financing, banks in today’s market generally won’t lend to business owners with a FICO score less than 650 even if the business is generating excellent revenues.

Lack of access to capital from banks has stalled many businesses’ efforts to grow and forced others to consider costlier options. In fact, according to data from PayNet, a small business credit tracking firm, the amount of capital offered by banks to small businesses declined 15 % between 2009 and 2015. During the same time period, costlier alternative lenders increased their market share from 10 % to 26 % and continue to grow.

Alternative Lenders Look at More than Credit Score

Alternative lenders provide loans to businesses based on the overall health of the business rather than the owner’s credit score alone. While lending to subprime borrowers may catch up to these lenders some day, so far at least these lenders are doing pretty well.

For example, take alternative business lender OnDeck. This company may lend to businesses with a FICO score as low as 500, as long as the business is at least 1 year old and generating more than $100K in annual revenues. They have coined their own score called the OnDeck Score, which company staff when evaluating loan applicants. The OnDeck Score encapsulates more than 2,000 data points, ranging from traditional credit data to cash flow and revenue data to social media data. This holistic score, OnDeck says, is a better way to grade Main Street businesses than the traditional credit score.

This approach is working out pretty well for OnDeck. They have originated over $3 billion in loans. One would expect borrowers to be defaulting on OnDeck loans at high rates since the borrowers are subprime. In reality, however, the default rate for OnDeck is around 5 %, on par with bank default rates. In fact, since they collect payments daily, OnDeck actually recovers more money back on loans that go into default than banks are able to recoup.

Other lenders that provide loans to bad credit businesses include Kabbage, Dealstruck, BlueVine, Fundbox, and more. As you might expect, these lenders charge much higher interest rates than a bank or SBA loan.

Why Bad Credit Doesn’t Mean Bad Business

Borrowers with bad credit may still be trustworthy from a lending and investment standpoint. Why? Because personal credit is often divorced from business success.A business owner’s credit may decline due to personal reasons independent from the business’ financial performance. Stephen Sheinbaum, the founder of alternative finance platform Bizfi, points this out. "If a credit card issuer cuts your credit limit, your score will drop, even if you've regularly paid your bills on time in the past. There are also people who experience unexpected health issues in their family, which forces them to delay paying certain bills and in turn damages their credit score.” In spite of personal financial troubles however, Sheinbaum says, entrepreneurs are usually “determined to grow their businesses.” In other words, you can’t make the leap from bad credit to bad business.

In other cases, the business owner’s personal credit may suffer because he or she is putting the business ahead of their personal finances. Joseph Camberato, President of alternative lenderNational Business Capital, has seen this firsthand: “We often see that a lot of business owners will sacrifice their personal credit in order to start their business. This comes back to haunt them when their business takes off and they require additional capital. Even though their revenue is in place, they have already sacrificed their good credit to reach that goal. Traditional lenders will hold this against them and likely deny their loan application.”

Alternative lenders seem to better recognize the difficulties inherent in running a business and will overlook a bad credit history if the business’ cash flow is positive.“We are far more interested in the business's cash flow than the personal credit score of the owner,” says Candace Klein, Chief Strategy Officer of alternative lender Dealstruck. “While we do look at the credit report, we are looking for specific late pays on recent debts, rather than the score overall.” Looking at business cash flow and recent problems on a person’s credit report makes more sense than analyzing the overall score. A person’s financial situation, particularly when they own a business, can change in a pretty short period of time. Should a borrower really be declined for a decade-ago late payment on a student loan even though her business brought in over $250K in revenues last year? Doesn’t make sense to me.

Bottom Line

The banks may have written off borrowers with bad credit scores, but alternative lenders and investors haven’t. Bad credit doesn’t necessarily mean bad business, and credit score doesn’t always tell you the whole picture about a business’ potential.

I am the founder of Learn Bonds and Bond Moves. Learn Bonds is an educational website focused on helping people better understand bond investing. The site explains concepts from compound interest to option adjusted spreads. Bond Moves brings together intra-day and daily com...